Greenspan defends role of derivatives

In a speech today, Alan Greenspan, chairman of the US Federal Reserve, defended the use of derivatives as hedging tools, especially credit derivatives. His comments come in the wake of Warren Buffett’s criticism of derivatives as potential “time bombs”.

Greenspan, speaking at a Banque de France symposium on monetary policy, economic cycle and financial dynamics in Paris, said derivatives have become indispensable risk management tools for many of the largest corporations. His theme was financial globalisation, and he said the development of new products, especially over-the-counter derivatives, has tightened the linkages between global financial markets.

“As a result, capital has flowed more freely across national borders in search of the highest risk-adjusted rates of return,” he said.

Greenspan said the marriage of derivatives and securitisation techniques in the form of synthetic collateralised debt obligations (CDOs) has broadened the range of investors willing to provide credit protection, by pooling and unbundling credit risk through the creation of securities that best fit their preferences for risk and return.

Greenspan highlighted Argentina’s recent default as a “powerful test” of credit derivatives that “proved their worth, even helping to limit contagion”.

On Monday, influential investor Warren Buffett, in a letter to his investment and insurance company Berkshire Hathaway shareholders, described derivatives as “weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”. He said large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers that trade extensively with each another.

Greenspan added that further development of derivatives markets, especially in smaller economies, is likely to facilitate greater cross-border flows and a more productive distribution of global savings. “The coincident development of local derivatives markets may facilitate the development of local currency bond markets in small or emerging market economies by giving foreign and domestic investors more tools to hedge their exposure to the country risk,” he said.